Wednesday, June 24, 2009

In a 2006 Bank of Canada working paper, (highly recommended) Issa, Lafrance and Murray showed that, sometime in the 1990s, a structural break occurred in the relationship between the Canadian dollar and energy prices. Whereas prior econometric estimation (see Amano and van Norden 1995) showed that higher energy prices lead to a depreciation in the Canadian dollar, the authors showed that this relationship no longer held and that in fact rising energy prices tend to drive the loonie higher.

This finding shouldn’t be a surprise to even casual observers of commodity and currency markets. The loonie has followed oil in virtual lockstep for many years, hitting 1.10 to the US dollar as oil rocketed past $100/barrel.

To me, it is not immediatley clear why rising oil prices should impact the loonie. Oil is traded in US dollars and so higher Canadian oil exports shouldn't impact the Canadian dollar since the sale of oil does not create additional demand for Canadian currency. However, higher oil prices do create demand for Canadian dollars for the purpose of FDI – international oil companies developing projects in the oil sands do need to pay for assets, labour, etc in local currency. The oil-price break-even rate on these projects is high and so investment is driven by price. Therefore, oil impacts the loonie through the capital account, rather than the current account. (at least that is my take, if I’m wrong, please feel free to tell me so).

I use a version of the Issa, Lafrance, Murray model that, as shown in the dynamic simulation below, tends to track the Canadian dollar fairly closely.

Dynamic Simulation of CAD/US Exchange Rate, 2004-2008

If we are conviced that oil price are a significant driver of the Canadian dollar, then it may be interesting to ask how a future oil price shock will impact the loonie vs. the greenback.The graph below sets out the baseline scenario for oil prices, based on EIA forecasts, and a somewhat arbitrary path for a hypothetical oil shock that would have the USD price of oil rise to $130 by the third quarter of 2010.

If the future path of oil prices looks more like the green line than the EIA forecast above, then, from the model, we should expect to see Canadian dollar back to parity early next year.

Rising oil prices may get the loonie near parity, even without a steep run-up in prices, particularly if accompanied by weakness in the US dollar. But if oil really starts to run, I think it is very likely that the loonie will approach, or possibly surpass, its previous highs.

Wednesday, June 10, 2009

I'm having a hard time with this one. The model I use for forecasting real GDP growth relies on changes in the slope of the yield curve as the mechanism by which monetary policy works. As discussed previously, the slope of the Government yield curve (10yr - 3month) has steepened dramatically in the past month. This steepening is often interpreted as a positive signal that market participants expect short-term rates to rise in the future as growth and eventually inflation pick-up. What I am having a difficult time with is whether this is the right way to interpret what is currently happening in the Canadian economy. The Bank of Canada is certainly not going to be raising rates any time soon, and research by the IMF shows that recoveries from recessions caused by financial crises tend to be slow.

The forecast implications are significant. Ignoring the signal from the yield curve implies a less robust recovery while accepting it provides a recovery akin to what the Bank of Canada forecast in its last MPR. The figure below illustrates the incremental growth implied by the yield curve shock (versus a control baseline of ignoring the signal, eg, running a simulation in which no steepening occurred

I'm leaning towards interpreting the movement in the yield curve as simply the normalization of inflation expectations and the impact of the "flight from quality" as investors regain confidence. Anyone want to try to convince me otherwise?

Tuesday, June 9, 2009

Milton Friedman famously proclaimed that “inflation is always and everywhere a monetary phenomenon”, implying that inflation is inextricably linked to the money supply. This thinking has lead some analysts and others to voice heightened fear that monetary stimulus provided by the Bank of Canada, and the Federal Reserve in the United States, can only lead to a resurgence in inflation.

Proponents of this view point to the recent increase in the slope of the government yield curve as a clear signal that purchasers of government treasuries, fearful of the impact of massive monetary and fiscal stimulus, are ratcheting up their inflation expectations and demanding a higher yield on long-term debt. Still others view the steepening yield curve as a positive signal of expected future growth and the end of the recession. So which is it? Looking at inflation expectations derived from Canadian real-return bonds, it is pretty difficult to conclude that Canadians, or buyers of Canadian debt, expect runaway inflation on the horizon. Inflation expectations seem to have ticked up recently, but I think only because a Great Depression II induced deflationary spiral seems to be off the table. Moreover, expectations remain firmly anchored in the BoC comfort rangeIt is also hard to conceive of a scenario in which inflation could get out of control while the economy is operating so far below its potential.

My own opinion is that the increase in the slope of the yield curve is a function of the following factors (in no particular order):

1) Flight from quality – investors getting out of treasuries and back into riskier assets

2) Normalized inflation expectations – fears of a deflationary spiral seems to have been successfully beaten back by the Bank of Canada

3) Expected Government borrowing due to larger than anticipated fiscal deficits

4) Expectations that the worst of the recession is over and the economy will return to positive growth soon.

Monday, June 1, 2009

Real GDP growth in Canada came in at -5.4% (annualized) for the first quarter of 2009. It turns out that my forecast of -8.2% was off by a wide margin. Thankfully, I had prestigious company with David Wolf (Merrill Lynch), Marc Carney and the Parliamentary Budget Office all missing substantially on the low side. The figure below shows how some prominent (and not so prominent) forecasters performed for Q1 Real GDP growth - I'll spoil the surprise - we still (mostly) suck at forecasting GDP.

I haven't had time to delve into the details, but much of the surprise seems to have come from higher than expected consumer spending. Personal consumption expenditures were actually less of a drag on growth in Q12009 than in Q42008. Investment was atrocious, as expected and growth was helped out a little by imports falling more than exports.

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